As U.S. markets remain in hibernation for a few more hours, Goldman picks out the five critical questions that need to be considered in the context of 2012's economic outlook. Jan Hatzius and his team ask and answer a veritable chart-fest of crucial items from whether U.S. growth will pick up to above-trend (and remain "decoupled" from Europe's downside drag), whether inflation will find its Goldilocks moment this year and if the U.S. housing market will bottom in 2012 (this one is a stretch).

Summarizing all of these in a final question, whether the Fed will ease further, the erudite economist continues to expect an expansion of LSAP (focused on Agency MBS) and an official re-adjustment to an inflation targeting environment. Their view remains that a nominal GDP target combined with more (larger) QE improves the chances of the Fed meeting its dual mandates (unemployment target?) over time but expectations for this radical shift remain predicated on considerably worse economic performance in the economy first (as they expect growth to disappoint). We feel the same way (worse is needed) and recall our recent (firstly here, then here and here) focus on the shift in the balance of power between the Fed and ECB balance sheets (forced Fed QE retaliation soon?).

Goldman Sachs: 5 Questions For 2012.

Today’s focus article discusses what we see as the 5 most important questions facing the US economy in the coming year.

First, will US growth pick up to an abovetrend pace? We think not. Underlying growth is probably considerably weaker than implied by our 3.3% tracking estimate for Q4 GDP growth; tight oil supplies act as a “speed limit” for global growth; fiscal policy remains a drag on growth; and the spillovers from the European recession are likely to increase.

Second, how much will the European crisis - the biggest downside risk - subtract from US growth? Our baseline estimate is 1 percentage point, but the uncertainty is large. On the one hand, we have not seen much impact yet...

On the other hand, a failure of peripheral European economies to stabilize due to a “paradox of thrift” situation in both the public and private sectors poses a downside risk for Europe and ultimately also the United States.

Third, will the US housing market bottom in 2012? We think yes. With excess supply diminishing gradually...

...and valuations back to “equilibrium,” we expect the house price decline to end in 2012H2, although the recovery is likely to look very U-shaped.

Fourth, will inflation be too high or too low by late 2012, relative to the Fed’s target? Too low, in our view. The commodity price impulse is waning and there is still plenty of excess capacity. We expect core inflation to fall back to 1¼% by yearend, clearly below the Fed’s implicit target.

Fifth, will Fed officials ease further? We think yes, probably via purchases of agency MBS (and perhaps Treasuries) announced in the first half of the year. We also expect Fed officials to provide a forecast path for the funds rate and adopt an official inflation target at the January 24-25 FOMC meeting.

[/b]

[b]We expect Fed officials to ease anew in the first half of 2012 via purchases of agency mortgage-backed securities, either on their own or combined with Treasuries. This forecast is based on ourexpectation that real GDP growth will slow to a below-trend pace and inflation will fall to a below-target rate in the course of 2012. With the level of output still far below potential, we believe that this would be a sufficient signal for Fed officials to decide to ease further. At a minimum, we believe Fed officials would be loath to end their securities purchases at the conclusion of “operation twist” in mid-2012, and additional purchases essentially require a balance sheet expansion.

In addition, we also expect the FOMC to provide forecasts for the federal funds rate in the Summary of Economic Projections (SEP) published four times per year, starting at the January 24-25 meeting. More likely than not, the FOMC will also move from its current all-but-official inflation target of “2% or a bit less” to an outright inflation target of 2%. These moves are somewhat independent of the shift to renewed QE.

We view the funds rate forecasts as a sensible step, because they are likely to enhance the communication of the Fed’s reaction function to incoming information. We are less sure about the inflation target because it might be misinterpreted as a shift away from the employment part of the dual mandate.

[/b]

[b]To counteract this impression, Fed officials are likely to emphasize that the inflation target is “flexible” and applies to the medium term, and also that unemployment remains far above their estimate of the structural rate. Although they are unlikely to go as far as to complement the official inflation target with an outright target for the unemployment rate, they might decide to state even more clearly that they aim for an unemployment rate in line with their estimate of the structural rate over the medium term.

Our own view remains that a move to a nominal GDP level target, complemented with potentially large amounts of QE, would provide a greater chance to achieve the Fed’s dual mandate over time. But while we would not rule out such a move if the economy performs significantly worse than our forecast, we do not expect Fed officials to embrace such a seemingly radical option anytime soon.

Disclaimers: GuruFocus.com is not operated by a broker, a dealer, or a registered investment adviser. Under no circumstances does any information posted on GuruFocus.com represent a recommendation to buy or sell a security. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The gurus may buy and sell securities before and after any particular article and report and information herein is published, with respect to the securities discussed in any article and report posted herein. In no event shall GuruFocus.com be liable to any member, guest or third party for any damages of any kind arising out of the use of any content or other material published or available on GuruFocus.com, or relating to the use of, or inability to use, GuruFocus.com or any content, including, without limitation, any investment losses, lost profits, lost opportunity, special, incidental, indirect, consequential or punitive damages. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. The gurus listed in this website are not affiliated with GuruFocus.com, LLC.
Stock quotes provided by InterActive Data. Fundamental company data provided by Morningstar, updated daily.